New Zealand Law Society - Update on post-termination problems in franchising

Update on post-termination problems in franchising

By Deirdre Watson

Post-termination obligations such as restraint of trade clauses are a common source of disharmony upon termination of a franchise, especially where the termination follows a souring of the relationship, where there are mutual allegations of breach, and where all trust and confidence between the parties has been lost.

Franchisees who have become embittered at their franchisor, who have lost faith in the franchise and who are at risk of losing their entire investment, will take desperate measures as they look to push the envelope in terms of their post-termination obligations. It is only human nature that an embittered or disenchanted franchisee will look to find ways that they can put to good use the skills and knowledge they have acquired as a franchisee.

In my experience, franchisees often underestimate the commercial factors that drive a franchisor to take enforcement action to ensure compliance with post-termination obligations, including restraint of trade enforcement. Not only will a franchisor regard breach of a restraint as likely to diminish the value of the franchise and harm its legitimate interests, it will want to take action to ensure it sends a message throughout the network to other franchisees who might be contemplating the same activity.

Cases I have reviewed in previous articles (“Update on restraint of trade clauses in franchising”, LawTalk 928, May 2019, pages 37-39; and “Enforcing restraint of trade clauses in franchise agreement”, LawTalk 913, December 2017, pages 27-29) show the court to be very willing to grant interim injunctions enforcing restraint of trade obligations.

In premises-based franchises (franchises where the business is being operated from a commercial or retail premises), it is important to franchisors on termination to not only restrict competitive activity by way of enforcement of a restraint of trade clause but also to gain control over the premises themselves or the way in which they are used after termination. A post-termination problem which not a lot of franchisors of premises-based franchises give adequate thought to at the outset of the franchise is what happens if they do not have an adequate contractual mechanism to control what happens to either the premises from which the franchise has been operating or the underlying business that has been operated by the franchisee.

Assignment of lease

Some franchise agreements will contain post-termination obligations that require the franchisee to assign, upon request, the lease of the premises to the franchisor. This obligation still requires the consent of the landlord, which the landlord might not be inclined to give, particularly if the franchisee has been in arrears and the landlord no longer has a favourable view of the franchise brand at that location. A clause like this will not assist a franchisor where there is no longer any lease in place but simply a holding over arrangement, meaning there is nothing much to assign anyway. In this regard, it is surprisingly common to see leases for franchise businesses not renewed and franchisees in occupation on a month by month holding over arrangement. Complicating matters further are problems that arise when the landlord is an entity related to the franchisee.

The spotlight was recently shone on this issue in Foodstuffs North Island Ltd v Ravla Trading Ltd [2019] NZHC 2357.

The franchisee purchased the premises from which it operated its Four Square franchise during the term of the franchise agreement. The agreement contained a standard restraint of trade provision and also a clause providing that if the franchisee wished to sell the business, the franchisee must first offer the business to Foodstuffs, the franchisor.

Following health problems of one of the directors of the franchisee (Mr Ravla), the franchisee approached the franchisor with a proposal for the franchisor to agree a joint termination, with Mrs Ravla to take over the running of the business and to rebrand as a “corner dairy” or “superette”.

When the franchisor understandably refused to agree to that proposal (pointing out that there was no ability for the franchisee to terminate unilaterally), a period of silence from the franchisee then ensued, during which time, it was later discovered, the ownership of the premises was transferred to the Ravla’s family trust. This change in ownership was then disclosed to Foodstuffs who were also informed that there was, in any event, no lease in place, only a holding over position and that the trust would not be granting a lease of or selling the premises to Foodstuffs.

High Court proceedings

The case came before the High Court as an interim injunction application to restrain the respondents (which included the family trust), amongst other things, from taking any steps to transfer to any party the franchise business or any interest or right of possession in respect of the premises.

There was no allegation of breach or lack of good faith against the franchisor, such as will sometimes typically be advanced in franchising cases. Clearly, the franchisee’s motive was purely one of self-interest.

In granting the injunction, and whilst making it clear that no final views were being expressed, Ellis J was of the view that it was seriously arguable that:

  1. The franchisee’s intention to transfer its business to some new entity was an anticipated breach of the agreement, in that it was without Foodstuffs’ consent and without first offering it to Foodstuffs.
  2. The franchisee’s transfer of the premises to the family trust was for the purposes of avoiding its obligations under the franchise agreement and the trust itself was a sham in so far as the transfer of the premises was concerned.

As to the balance of convenience, Ellis J was of the view that there was little undue prejudice that might be suffered by the respondents whereas, by contrast, Foodstuffs would suffer damage to the goodwill of its brand and its goodwill at the premises. Further, that damage would have a broader deleterious effect on other Foodstuffs’ franchisees and on the franchise system itself.

Foodstuffs no doubt pursued this application because it identified that, without the ability to control or get access to the premises (with which the goodwill and its brand was associated), enforcing the restraint in and of itself would be fairly pointless.

The case serves as a strong warning to franchisees and their advisers that the court will be willing to see through sham arrangements where they have as their outcome and purpose the avoidance of contractual obligations under a franchise agreement. Given that the costs of High Court litigation are not normally within the ready grasp of most franchisees, franchisees would be well advised to explore other options before setting out to avoid contractual obligations under franchise agreement, particularly where there is no fault or breach on the part of the franchisor.

Deirdre Watson deirdre.a.watson@xtra.co.nz is an Auckland barrister, specialising in franchising. She lectures in franchise law at Auckland University, is a frequent presenter and speaker on franchise topics, and is Vice Chair of the Franchise Association of New Zealand.

Lawyer Listing for Bots